Castles in the Sky (Updated)

Volume V, Number 5 -- Updated July 12, 1999

Encouraged by the optimism of the latest official projections, both sides in the budget debate are embracing a seductive fantasy: that we've entered a new era of guaranteed fiscal plenty in which the only important question is how to divvy up the large and growing surpluses projected over the next decade. How much of the extra cash should be committed to Social Security? How much to Medicare? How much to tax cuts?

To judge by the rush to spend the surplus, you'd think today's projections were set in stone. But they're not. The Congressional Budget Office (CBO) acknowledges that its projections of the federal budget balance made five years in advance have, on average, been off by 13 percent of projected outlays. With this margin of error, the $266 billion surplus anticipated in CBO's July baseline for the year 2004 could just as easily come in at a paltry $15 billion. And beyond five years, warns CBO, the projections are even more uncertain.

In fact, it wouldn't take anything so dramatic as a major recession or war to push the federal budget deep into deficit again by the end of the next decade. If official expectations--about discretionary spending, or health-benefit costs, or economic growth--turn out to be even slightly optimistic, the castles in the sky political leaders are building will all come tumbling down.

Let's Suppose

What's easy to forget is that the federal surplus or deficit is just the thin margin between two much bigger numbers, spending and revenue, and that small changes in either can have a huge impact on the fiscal bottom line. It's like a pair of scissors: Gently squeeze the handles, and the two blades rush together.

Discretionary spending, which includes everything from the national parks to the national defense, is sure to be one source of pressure. The CBO assumes that the discretionary caps in effect through 2002 will be honored, which means that its baseline presupposes cuts in real spending totaling 8 percent over the next three years. Although this may be "current law," the cuts have yet to be enacted, since Congress only votes on discretionary spending one fiscal year at a time. More to the point, political leaders have no idea how to meet the caps--and commentators across the nation are assuming that they will be ignored, evaded, or outright repealed.

Let's suppose that the caps are breached, and that discretionary spending keeps pace with inflation over the next decade. This alone would be enough to shrink the surplus that CBO now projects for the year 2009 by $82 billion--from $413 billion to $331 billion.

In fact, discretionary spending may rise faster than that. As a share of GDP, nondefense discretionary spending is now at its lowest level since LBJ announced his "Great Society" in 1965. It can't fall forever. Sooner or later, it is likely to grow again at least as fast as the population and real economy. (Think of schools, highways, or the federal payroll.) As for defense spending, this is now at its lowest level since before Pearl Harbor. It's not hard to imagine some combination of national security challenges--from building a "star wars" defense system to deploying international peacekeeping forces--that would require it to rise sharply as a share of GDP (as it did during the Reagan build-up). But let's leave aside that possibility and consider what happens if total discretionary spending merely keeps pace with GDP. In that case, the surplus projected for 2009 would shrink not to $331 billion, but to $151 billion.

Good Reasons for Skepticism

Today's surplus projections also assume that the growth in health-benefit costs will be relatively slow over the next decade. Under the CBO baseline, real per beneficiary Medicare spending is expected to rise at 4.2 percent per year, a full percentage point beneath its long-term average since 1970. The result is supposedly guaranteed by the 1997 Balanced Budget Act (BBA).

Will this expectation be borne out? There are good reasons for skepticism. The latest data show that private-sector health costs are accelerating, which will put upward pressure on Medicare as well. Industry groups are busy lobbying Congress to ease up on the BBA's reimbursement cuts--a demand that may prove difficult to resist now that the budget is running surpluses. HMOs, on which the BBA depends for much of its savings, are starting to pull out of unprofitable Medicare markets. Meanwhile, a growing chorus of voices, President Clinton included, are urging new benefit expansions, with prescription drug coverage topping the list.

Let's suppose that all of this means that Medicare ends up growing 1 percent per year faster than projected--in other words, roughly in line with the long-term historical trend. The result? If discretionary spending also keeps pace with GDP, the surplus projected for 2009 would narrow to just $95 billion.

Controversial Arguments

Then there are the economic projections, where any number of plausible developments could have an enormous impact on the fiscal bottom line.

Consider productivity, which has grown at 1.1 percent per year since 1973. CBO calls this trend "quite stable." Yet in its baseline, CBO assumes that productivity growth will average 1.8 percent over the next decade. Why this huge boost? About half, says CBO, is a technical correction for the fact we have been mismeasuring productivity in the past. The other half is explained by a rise in the capital-to-labor ratio. Both arguments are controversial. Still, let's grant CBO its optimism--only let's suppose that productivity rises just half as much as it anticipates. What happens to the projections? Assuming that discretionary spending also keeps pace with GDP and that Medicare grows 1 percent faster than projected, the surplus of $413 billion projected for 2009 becomes a deficit of $27 billion.

Productivity isn't the only economic assumption the official projections may have wrong. In the 1990s, we've gotten used to historically high labor-force participation and historically low unemployment. What if the number of workers grows just one-quarter of a percent slower annually than CBO projects--due to some combination of fewer people seeking jobs and fewer finding them? The deficit in 2009 grows to $102 billion.

Looking for Excuses

The truth is, these aren't the only sensitive assumptions underlying the projections. Capital gains revenue has soared along with the stock market. What if the market crashes? The effective tax rate has risen along with the growing inequality of incomes. What if future income gains are more broadly shared? Our purpose is not to make predictions. Rather, it is to show that only minor deviations from current favorable expectations can dramatically alter today's budget outlook.

It's time to stop building castles in the sky. We face the same basic long-term fiscal choices today we faced five or fifteen years ago. Back when the budget was in deficit, leaders used to say that fiscal responsibility was too painful. Today, with the budget in surplus, at least for the moment, they say that it's no longer necessary. Now as before, they're looking for excuses. It's time the American public demanded more candor and courage. ¦